Means-Testing Retirement Benefits in the UK - Is it Efficient?

Those who are eligible for means-tested benefits have a lower incentive to save since the effective return on private retirement savings is reduced relative to those who are not eligible. The strength of the distortion depends on the taper rate which defines the amount of benefit reduction for every additional £ saved. However, while lower taper rates reduce savings distortions of those who are already eligible they also increase distortions for those who are newly covered by the system. When more households receive benefits, contribution rates and labor supply distortions also rise again. Consequently, the optimal taper rate has to trade off distortions of labor supply and savings against distributional and social insurance objectives. A further question arises with respect to the differential treatment of different types of private resources. Especially in countries that operate a multi-tier pension system the optimal system design may include different taper rates for private and second tier pension wealt. Consequently, although means-tested benefits are typically included in pay-as-you-go financed social security systems, the organization differs substantially across OECD countries with respect to benefit generosity, household coverage and the targeting of resources.

The present paper attempts to shedmore light on the economic mechanics and costs of means-testing by taking a recent reform of the UK pension system as a starting point.